Distorting the Market, or Making It Work?

Much of the vehementlynegativereaction to the Geithner plan boils down to a simple assertion: the plan is bad because it maintains the fiction that the banks are okay, instead of insolvent, and because it’s meant to keep them afloat, rather than simply nationalizing them. While the plan’s opponents have also attacked some of the particular details of the plan, in some sense those attacks are tangential: ultimately, the disagreement (to put it mildly) that people have with the Geithner plan is not with its details, but with its fundamental premises. Indeed, no matter how Geithner constructed the plan, there is no way it would have passed muster with most of the econo-blogosphere, precisely because it doesn’t call for nationalization.

There is one detail of the plan, though, that people are particularly bothered by, and that is the fact that the plan involves the FDIC guaranteeing loans to private investors. (The way the plan to buy pools of mortgages is set up, investors will be able to borrow six dollars for every one dollar they invest. If their bets go bad, they lose only the one dollar they invested—the FDIC is responsible for paying back all the borrowed money.) Paul Krugman, for instance, calls this the “central issue,” and argues that because the non-recourse loans are a massive subsidy to investors—which they are—the plan will distort the prices that investors are willing to pay for these assets, and therefore “has nothing to do with letting markets work.” Ezra Klein, similarly, argues that because the plan relies on these “non-recourse” loans, the prices it will produce will be in some way “artificial.” Their point is that the Geithner plan, among other things, is supposed to produce real market prices for these toxic assets, which will then give us a better picture of banks’ balance sheets and allow us to avoid valuing these assets at prices that the government thinks have become unduly low because investors are so risk-averse. But by creating a plan in which investors have only a small downside and a big upside, we’re supposedly creating fake prices.

There’s no doubt that the non-recourse loans constitute a big subsidy: while investors’ downside risk isn’t eliminated, since they can still lose all the money they invest, that risk is significantly limited, while their potential upside is significantly increased (since they’re leveraging every dollar they invest six-to-one). Yet for all the criticism of this subsidy, the truth is that the plan’s reliance on non-recourse loans is not an especially radical idea. In fact, it’s essentially the same kind of subsidy that the entire U.S. banking system has depended on for the last seventy-five years. What are FDIC-insured bank deposits, after all? They’re non-recourse loans to banks. You deposit money with a bank—that is, you lend it your money. The bank can then take that money, and leverage it up nine-to-one to make loans or acquire assets. If the loans are good, they keep all the profits. If the loans go bad, the most the bank can lose is the capital it’s invested. All the rest of the bank’s losses are paid for by the FDIC. This is precisely the same arrangement — down to the loans being guaranteed by the FDIC—that the Geithner plan sets up. In effect, it just extends to outside investors, for the purpose of acquiring toxic assets, the same subsidy that banks have been receiving since 1933.

This doesn’t mean that the loan guarantees are necessarily a great idea. It’s just to say that if, as people are arguing, government subsidies make a price “artificial,” then most loan prices, and most housing prices (since they depend on mortgage rates) in the U.S. have been artificial for the last seventy-five years, because those prices have all been set by institutions that were benefiting from massive non-recourse loans subsidized by the FDIC. And if you think that non-recourse loans will inevitably distort prices by making investors willing to pay too much for assets, then you’re saying that loan and house prices in the U.S. have been overvalued since before the New Deal.

Now, maybe they have been. But I’m not sure how meaningful it is to say that lending in the U.S. since the nineteen-thirties has had “nothing to do with letting the market work.” With some obvious exceptions, like the housing bubble, I think most people would say that the lending and housing markets have functioned reasonably well since the thirties, and all along they’ve depended heavily on subsidized loans. And that, at least, should make us wonder whether the Geithner plan’s similar reliance on non-recourse loans really is as much of a recipe for distortionary pricing and overvaluation as it’s been made out to be.